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24 November 2009

Calculating an ROI for a specific improvement initiative

Here is something that is rarely done effectively in preparing for traditional ERP – an Everything Replacement Project: our management team at the example company (see prior posts) now has everything it needs to calculate ROI for the specific warehouse and pick-ship initiative they have under consideration. Here is the formula they will apply:

ROI = (delta-T – delta-OE)/delta-I

Where T = ThroughputOE = Operating ExpensesI = Investment

Substituting into this formula the numbers calculate by the team (see prior post), we get:

ROI = $0 – (-$168,942)/$75,000 = 225.3% in the first year

"But," you say, "this company will not experience the full $168,942 in savings in the first year!" And, of course, you are correct. The management team recognizes this also. So, they quickly do some "napkin" calculations and estimate that, as revenues grow, they may reap about 40% of the calculated annual savings through deferred hiring of additional FTEs (full-time equivalents) in the first 12 months following the implementation. This means our first-year calculations need to be adjusted as follows:

What these calculations tell the management team is this: "If we invest up to $75,000 in an initiative to improve processes highlighted by our Current Reality Tree (CRT) (see prior posts) in the areas of bar code printing, ASN (advanced shipping notice) processing, and picking-shipping operations; and our Throughput continues to grow; then we ought to see about 90% of the money invested in this initiative returned in savings to the organization within the first 12 months following deployment." (Note: The real firm upon which this scenario is predicated had been experiencing double-digit growth in sales for more than five consecutive years when I was introduced to them.)

This also tells the team that, in subsequent full years, since no additional investment is required (unless they should wish to capitalize some portion of the software maintenance), the company should continue to reap about $169,000 in annual savings as a reward for this effort. (Note: If anyone wishes to extrapolate further from these figures, it would be possible to calculate the Net Present Value [NPV] of the series of estimated cash flows resulting from this or any other particular Extended Readiness for Profit – the New ERP – initiative. While this is not generally required for initial decision-making, the true value of the initiative – and, indeed, the value of the firm as a whole – is best represented by the NPV of "the system.")

4 comments:

On our website we provide a 12 page Business Value / ROI Calculator that allows prosective customers to examine where possible gains could be made with a way for them to dynamically edit numbers including confidence. We hope this gives them a reason as to why do anything. And no we don't make them leave their contact information

Thank you for posting the link. I'm certain that some of our readers will find it to be of interest. However, I am equally certain that you are aware of some of the weaknesses of the analysis provided by your calculator.

Without trying to be too harsh, a beginning list would include:

1. Every assumption in the calculator is predicated upon one -- and only one -- user input: namely, "Number of Employees". This is hardly likely to produce accurate results for any company. In fact the results may not even be in the ballpark -- they may be too high, or they may be too low; but the numbers are not likely to be "correct" within a reasonable margin of error.

2. These numbers are coming from the vendor. The management team did not do the "leg work" to figure out WHAT NEEDS to CHANGE, or WHAT the CHANGE should LOOK LIKE.

3. The ROI calculator print-out does not really tell you WHAT WILL CHANGE or WHAT the CHANGE will LOOK LIKE except in the broadest of terms. For example: Why would margins necessarily increase due to "Inventory Transparency"? Why would making the proposed investment in technology lead to a "Higher Average Selling Price"? Without knowing how much (or how expensive) the inventory being carried by any given firm is, how can the calculator assume any dollar value for "Reduced Inventory Carrying Cost"?

I could go on, but I think you get my point. Perhaps you would like to respond and compare this to The New ERP methodology I have proposed.